Fed Cuts Rates Quarter Point

April 30, 2008

By SCOTT MAYEROWITZ ABC NEWS Business Unit

The Federal Reserve once again cut a key interest rate, trying to do whatever it can to keep the economy from grinding to a complete stop.

Today's quarter-point cut brings the Fed Funds interest rate to 2 percent. It was the seventh such cut since September, when the central bank first started to lower rates — then at 5.25 percent — in response to a collapsing housing market and the tightening of credit.

The last time interest rates were this low was December 2004.

This cut might be the last one for a while. Many economists and investors expect that at some point soon the Fed will take a pause in its rate-cutting.

"Recent information indicates that economic activity remains weak. Household and business spending has been subdued and labor markets have softened further," the Fed said in its statement. "Financial markets remain under considerable stress, and tight credit conditions and the deepening housing contraction are likely to weigh on economic growth over the next few quarters."

While Wall Street investors typically like such moves, this rate cut is likely to have little, if any, impact on most Americans. Rates on mortgages, credit cards, student loans and other types of loans in the past benefited from such a cut, but now are unlikely to change substantially because of this move.

The latest cut, however, could mean higher gas prices for Americans.

Nevertheless, Joel L. Naroff, president and founder of Naroff Economic Advisors, said the Federal Reserve made the right decision.

"Cutting one more time, it doesn't do a whole lot," Naroff said. "But it's a chance for the Fed to signal that it intends to stop the rate reductions. The simple fact is short-term rates are low already. They don't need to go a whole lot lower. The problem is not the level of rates, the problem is the availability of money and that's the credit crunch, liquidity problem."

Naroff said the Fed's work isn't done, and it must now shift away from cutting interest rates and focus on finding ways to provide more working cash to the banks to make loans.

"If they cut interest rates to 1 percent today, that wouldn't cause the financial institutions to suddenly start lending lots of money," he said. "The problem is, they're not willing to lend money because they've become so conservative because of all the losses they've absorbed."

For the Federal Reserve, setting the nation's momentary policy has always been a balancing act.

On one side of the scale, the central bank wants to keep interest rates low to make it easier for individuals and companies to borrow money — essentially to stimulate growth. But on the other side, the Fed runs the risk of making interest rates too low, creating too much inflation and pricing Americans out of everyday goods.

For months, Federal Reserve chairman Ben Bernanke and his board have grappled with that balance. Late last summer it became apparent that the housing market was collapsing, and the Fed started an aggressive rate-cutting regimen.

For now, it appears that Bernanke has done all he can with interest rates.

Peter Morici, a professor at The Robert H. Smith School of Business at the University of Maryland, said that regardless of what the Fed does, the banks don't have access to cash.

"Insurance companies, pension funds and other fixed-income investors will not loan money to the banks after the subprime debacle until they're convinced that [the banks] have cleaned up their securitization process," Morici said.

But Morici said he doesn't think this will be the end of rate cuts.

"With the kind of unemployment numbers we're getting, I think the Fed will find itself lowering rates yet further in the future," he said. "It would like to pause, but I don't think it's going to be able to get away with it."

"The economy will likely slow more than it is estimating," Morici added. "We are likely to have a recession, but now it will be in the second and third quarters as opposed to the first half of the year."

What a Rate Cut Means

While Wall Street usually loves such a rate cut, the Fed's action will ripple throughout other parts of the economy.

The most dramatic and immediate result is that the U.S. dollar will fall further against foreign currencies whose central banks haven't been as aggressive at cutting rates.

A lower dollar also means higher oil prices. Oil is now trading at close to $120 a barrel. In January 2007 oil traded at less than half that: about $50 a barrel.

Many Americans are feeling those higher prices at the pump, where a gallon of regular gas now costs an average of $3.60 across the country, according to the government's Energy Information Administration.

The cheap dollar does help some companies, especially those that manufacture goods in the United States and sells them overseas. Those products are now cheaper for the foreign buyers and demand has gone up.

Investors want lower rates because cheaper loans mean more borrowing and spending by consumers and businesses. With lower rates, businesses find it easier to expand.

So what about consumers?

Most people's short-term loans, such as credit card debt, are tied to the prime rate, which is generally three percentage points higher than the Federal Funds rate.

Cheaper Mortgages?

Longer-term, fixed-rate loans such as mortgages and college student loans are tied to Treasury bonds, which are not directly affected by the Fed's decision. So don't expect any immediate relief. Treasury bonds typically take on some of the Federal Funds rate momentum and are normally move down after such rate cuts. But in recent months, such traditional moves have not occurred because lenders are hesitant to give out money, pushing up some rates.

The Fed rate cut might not provide much relief for homeowners with variable-rate mortgages, but the cut means that core rates probably won't go higher for them. It might not be enough to stop the sharp rise in foreclosures, but it is likely to help some of the people on the edge of making their payments.

But even if rates do go down for some homebuyers, only those with near-perfect credit are likely to see the benefits.

When interest rates were this low just a few years ago, many Americans became first-time homebuyers. Some had spotty credit and many lenders did not require documents verifying income or assets.

Many of those so-called subprime borrowers have now defaulted on their mortgages, leading to a major fallout for home-sale prices and the banking industry.

Lenders have tightened their loan standards. So even if mortgage rates decrease now, many Americans can't refinance their existing mortgages. This is compounded by falling house prices, which makes it tough for even those with good credit to refinance.

The Mortgage Bankers Association reported today that applications for new mortgages and for refinancing are both down: new mortgages by 11 percent and refinancing by 16.7 percent from the prior week.

Credit Cards

Some people with an outstanding credit card balance are likely to see some relief, but not immediately.

Variable-rate credit cards are set using a formula tied to the prime rate, but most variable-rate cards don't "float." They shift at fixed times throughout the year, so it's unlikely there would be a substantial immediate impact. Also, fixed-rate cards make up the majority of the credit card market and they don't change much at all.

Also directly affected are people who have home equity lines of credit. These loans are usually tied to the prime rate so they will be directly impacted.

Car Loans

Finally, people with car loans are not going to see any relief because those rates are typically locked in at the time of the purchase. However, anybody seeking a new loan for a car purchase will likely see lower rates.

The key for any consumer is to shop around and read the fine print. So if your credit card rate doesn't lower, shop around — maybe another bank has lowered its rates.

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